It was the best of times for the U.S. stocks in 2013. It was also the worst of times, however, for just about everything else in investment markets last year. Given this stark contrast in performance between stocks and all other asset classes, it is reasonable to consider whether or not we are likely to see this trend continue into 2014. While anything is possible in today's policy distorted markets, the odds are stacked against such a resounding repeat performance for stocks in the coming year. Instead, the playing field is likely to be leveled in 2014 with opportunities spread more evenly across asset classes. And volatility, a stranger to the stock market throughout nearly all of 2013, also has the potential to return in earnest next year.
Reflections on 2013
In looking ahead to the coming year, it is worthwhile to first reflect briefly on the year that has just drawn to a close, as it has important implications on the year ahead.
So what exactly were we expected heading into 2013 around this time last year?
· Corporate revenue and earnings growth would continue to stall
· Economic growth would likely remain sluggish
· Deflation would remain the primary concern, not inflation
· Geopolitical and financial market instability remained a meaningful threat
Putting all three of these factors together in a rational market environment would reasonably imply the following outcome for 2013. Stocks (SPY) should struggle, particularly since corporate profit margins were already at historical highs and stocks were trading nearly 10% above their long-term average valuations heading into the year. Bonds (AGG) should perform well despite the fact bond yields were already low, as the combination of slow growth and deflationary pressures provided continued support. And the potential for a financial market episode implied that gold (GLD) and other precious metals (CEF) should at least hold their ground if not modestly rise, particularly since they had been sold off in 2012, as investors seek to protect against potential instability.
So what ended up taking place in 2013?
· Corporate revenue and earnings growth stalled
· Economic growth remained sluggish
· Deflation remained the primary concern, not inflation
· Geopolitical and financial market instability reared its head several times
All of the events in the bulleted list above played out in 2013. Despite robust expectations on Wall Street heading into the year, corporate revenues and earnings growth continued to grind in the low single digits on both readings. Moreover, economic growth remained sluggish and fell short of consensus expectations, as the strong second half recovery predicted by many never materialized. Deflation is still the primary concern for policy makers as we enter another year. And the threat of financial crisis surfaced on several occasions throughout the year including a banking crisis in Cyprus, a period of spiking volatility in the traditionally sleepy Japanese bond market, the near seizure of the Chinese financial system in June and a number of major emerging markets including Brazil (EWZ), India (EPI) and Turkey (TUR) buckling under the pressure of major capital outflows.
In short, the economic and market outlook played out almost exactly as expected. But how all of this translated to investment performance was turned completely upside down. Instead of falling, stocks advanced strongly. Bonds, on the other hand did not register gains, but instead posted declines that were the worst for the bond market in nearly two decades. As for precious metals, solid gains were replaced with crushing losses with gold and silver (SLV) losing roughly one-third of their value.
So what exactly happened that might explain this dramatically wide deviation between what would be rationally expected from markets in a normal environment and what actually happened in 2013? Of course, the one key wild card last year was the ongoing pursuit of extraordinarily aggressive monetary policy from the U.S. Federal Reserve and other major global central banks. The U.S. Federal Reserve alone printed more than $1.1 trillion of fresh new money out of thin air as part of their latest QE3 stimulus program. This represented an incredible 35% increase in the size of their balance sheet in just one year's time. Such policies have become widely known to have a wildly distortive effect on asset prices. But this is on this point where the story in 2013 was all the more interesting.
During previous rounds of QE stimulus by the Federal Reserve, we saw a decidedly different outcome with virtually all asset prices rising to varying degrees. The only exception had been U.S. Treasury (TLT) prices that have traditionally performed poorly during periods of QE, which of course is ironic since higher Treasury bond prices and subsequently lower Treasury yields has been the reason proclaimed by the Fed for these QE programs in the first place. Otherwise, everything else would go up including U.S. stocks, emerging market stocks (EEM), corporate bonds (LQD), high yield bonds (HYG), TIPS (TIP), real estate (VNQ), commodities (DBC), precious metals and others. You name it, and it was going up.
This is what made how the latest round of QE played out in 2013 all the more notable. U.S. stocks did rise smartly in 2013 as might reasonably be expected under QE3 and despite the fact that underlying fundamentals had stalled. And so too did developed international markets, which were led by some of the most dubious economies in the aftermath of the financial crisis including Italy, Spain and Greece. But other than that, virtually every other asset class ended the year flat to down, if not down a lot. Emerging market stocks? Down. China (FXI)? Down. Preferred Stocks (PFF)? Down. High yield bonds ? Barely higher. REITs (IYR)? Down -15% since May. Treasuries ? Down more than -10% in some cases. TIPS ? Down nearly -10%. Corporate bonds ? Down Municipal bonds (MUB)? Down. Emerging market bonds (EMB)? Down. Commodities ? Down sharply. Gold and silver ? Completely crushed.
In the end, U.S. stocks posted one of the largest yearly outperformance gaps over all other major asset classes over the last century in an environment where the underlying fundamentals were lackluster at best and arguably more favorable for these other asset classes. 2013 was an extraordinary year to say the least.
Looking Ahead to 2014
As we enter 2014, the expectations are for the following:
· Corporate revenues and earnings growth should remain stalled at best
· Economic growth should remain sluggish
· Deflation should remain the primary concern, not inflation
· Geopolitical and financial market instability remain a meaningful threat
In short, we find ourselves staring at potentially the same economic and market outlook that we did a year ago. If anything, it might be somewhat worse.
This is great news right? After all, if stocks exploded higher last year under similar conditions, shouldn't they just do the same again in 2014? Simply extrapolate forward and watch the S&P 500 climb to 2400 by the end of the year, Q.E.D. Perhaps this will be the case, and investors should allocate to protect against such an outcome playing out for to stocks in the coming year.
But with this being said, it is likely going to be much harder for stocks to pull off a repeat performance in 2014 for the following reasons.
"Be fearful when others are greedy, and greedy when others are fearful"
To begin with, a key issue is the troubling behavioral realities of today's market. For example, margin debt to purchase stocks is at record highs and investment sentiment remains at bullish extremes. In other words, investors are acting greedy by borrowing money hand over fist to buy stocks in a market about which they are simply ebullient and not at all fearful. But what exactly are they really excited about? It isn't a robust economic recovery. It's not a strong surge in corporate fundamentals. Instead, it is nothing more than excitement based simply on the fact that stock prices are going up. We've seen this game play out twice before in recent years, and it always ends badly. For while the Fed can incite animal spirits in the stock market or the housing market for a period of time, they remain unable to successfully push on a string and turn these policies into the animal spirits to ignite sustained economic growth. Instead, they ultimately lead to new periods of volatility and unintended consequences.
Another very important challenge is that the stock market will increasingly be losing the fuel that drove its strong gains in 2013. At the end of 2013, the U.S. Federal Reserve announced that it was finally beginning to scale back its asset purchases in an effort to wind down its QE3 stimulus program. While the Treasury purchases that have been so vital in driving the stock market will continue to provide support early in 2014, the benefit will fade as the Fed continues to wind down the program as the year progresses.
Third, the Fed is not the only major central bank now tightening. The People's Bank of China has been working in vain at times to try to rein in the excess liquidity sloshing around in their economy. The fact that China is desperately trying to tighten monetary policy to contain widespread credit and housing bubbles in their economy suggests growth may be slower than expected going forward in the world's second largest economy. This developing risk from the emerging world, which has been a key driver of global growth for years, may result in a new phase of increased global market volatility looming on the near-term horizon. In fact, we saw strong hints of these risks already bubbling to the surface in 2013, and they may amplify further in the coming year.
Fourth, stocks simply cannot rise to the sky without fundamental support. It would have been great if stocks advanced in 2013 behind strong revenue and earnings growth. But this was not the case last year. In fact, it also was not the case for most of the previous year either. Since early 2012, we have seen U.S. stock advance by over 35% at a time when annualized corporate revenue and earnings growth have increased by less than 3%. In other words, stocks have risen for the last two years almost purely based on the hope that things are finally going to get better in the future.
This, of course, leaves us with the following tenuous situation for stocks. Even if the economy accelerates dramatically at this point, it now has a huge gap to fill for the anticipated growth that has not yet occurred but has already been priced into the market. And if it turns out that economic growth does not accelerate as anticipated and instead remains sluggish as expected, or worse yet actually slows further in 2014, this means that stocks will need to keep floating on air for another year just to hold their ground where they are now with any further gains being fueled by even more valuation expansion. But with stocks now trading at a historically expensive 19.1 times trailing 12-month reported earnings, this is a very tall order particularly with the tailwinds of monetary stimulus fading away as the year goes on.
A final obstacle for the stock market in the year ahead worth noting is what may be a definitive change in tone and focus among policy makers that may increasingly emerge as we move through 2014 and toward the mid-term elections.
For example, President Obama over the last several weeks has introduced what appears to be a major policy theme for the remainder of his presidency in economic inequality. Given that robust stock market gains in a lackluster economy since the beginning of his presidency have been a primary driver of the increasing income disparity being seen today, investors should not be surprised if the tone and perhaps the policies coming out of Washington are far less market friendly than they have been in the past. After all, it becomes an increasingly difficult narrative as a leader to even mention that the stock market is setting fresh all time highs as evidence of an improving economy with the labor force participation rate at lows last seen in the 1970s, with fewer Americans employed today than prior to the outbreak of the financial crisis and real median household income still down nearly -10% from 2007 levels.
Another example is the coming changes at the U.S. Federal Reserve. A new Chair is being installed at the Federal Reserve with Janet Yellen, who was appointed by the President and is also no stranger to the topic of economic inequality, taking over the helm from Ben Bernanke in January. Along with the change at the top, the Federal Open Market Committee (FOMC) charged with setting interest rate policy will be either changing or rotating in number of new voting members in 2014 that in aggregate are far more hawkish on monetary policy than the departing group from 2013. Given the fact that the Fed essentially found itself trapped in its QE3 program for much of 2013 and spent the second half of the year trying to plot a way to begin extracting themselves from more asset purchases without inciting a market riot, this more hawkish bunch may be more likely to seize on the opportunity to end asset purchases as soon as reasonably possible. The fact that they jumped at the opportunity to begin scaling back the program in December before the end of Bernanke's term highlights how badly the Fed wants to get out of the QE business. And given that the Fed has succeeded in artificially goosing stock prices to new record highs with little in the way of economic improvement to show for it, the potential exists that they may now be shifting their policy focus toward something other than the U.S. stock market under new leadership. In short, once the Fed finally extracts themselves from the Treasury purchases that have been so critical to stock market gains over the last several years, they may never come back even if the economy continues to struggle and the stock market falls.
Taking all of these factors together coupled with more taxes and the ongoing uncertainty of changes related to the health care law leads to a conclusion that the stock market has its work cut out for it to generate further gains in 2014. That's not to say that it won't, but any such gains are likely to be much harder won in the coming year than they were in the past twelve months. And the risks to the downside for stocks are far more meaningful today than they were a year ago. Thus a risk-controlled strategy that seeks to capitalize on returns but also protects against downside volatility in the stock market may prove far more valuable in the coming year than it did in 2013.
A World Of Investments Beyond U.S. Stocks
The fact that U.S. stocks face a far more challenging year in 2014 should not obscure the fact that outstanding opportunities are likely to exist in many other asset classes. In fact, extraordinary upside opportunities may even present themselves in the U.S. stock market as the year progresses, particularly if markets can find a way to work off the froth accumulated over the past two years and fall toward prices that better represent underlying fundamentals. But in the end, the best opportunities are often not found in chasing what has already taken place for the last five years in a stock market that is now trending far above its historical mean. Instead, they are found in those categories that have been either disregarded or discarded and are now trending well below their historical mean.
Looking ahead, the following are some potential investment themes that may be setting up well as we move through the early part of next year.
Stocks have the potential to continue rising in the short-term as Fed stimulus continues to flow in a meaningful way at least for now during what is also a seasonally strong period for the stock market. But if volatility has not already introduced itself to the stock market in the first few months of the year, it may return with an increasing vengeance the longer it waits to finally arrive, as the potential for a sharp correction in the -15% to -20% range or more for stocks is meaningful as we progress through 2014. In terms of stock allocations, an emphasis on quality, value where it can still be found and income should all be generally well served while also providing a degree of downside protection in the event stocks finally enter into correction. A focus on interest rate sensitive sectors that have already corrected, in some cases sharply, may also prove worthwhile as we move through 2014. Also, maintaining a close eye if the opportunity presents itself to capitalize if stocks appear poised to fall into sharp correction may also prove beneficial, although any such allocations must be undertaken with a strong risk controlled framework to protect against any such downside related to holding such a position.
Bonds have the potential to find their footing after what was a difficult 2013. This is particularly true if global economic growth remains sluggish and deflationary pressures persist. And it is likely to be even more so true if a major financial episode erupts in 2014 that sparks a flight to safety among investors. The one wild card would be if major holders of U.S. Treasuries are compelled to liquidate their holdings amid any related liquidity pressures. A key for the bond market in 2014 will be determining exactly where the floor resides for bond yields including the 10-year Treasury yield at 3%, 3.25% or perhaps even higher. It is also worth remembering that Treasuries rank among the best performing asset classes when the Fed has exited its QE stimulus programs in the past.
As for commodities, while the sector offers tremendous upside potential, it remains an area to proceed with great caution. In regards to the industrial metals space, prices are likely to decline as long as China works toward tightening monetary policy. And some of the unusual trading activity needs to subside and a definitive breakout to the upside must be established before considering an allocation here.
Investment markets always present interesting opportunities regardless of the market environment, and 2014 is likely to be no exception in this regard. But it is a year that is also likely to require periods of patience in waiting for trends to fully play themselves out and corrections to take place. And it may not necessarily be the U.S. stock market where these opportunities are derived. Thus, discipline and a universal perspective, more than anything else, may find itself being the most rewarded of all by the time we arrive at the end of 2014.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Additional disclosure: I am also long SPLV and selected individual stocks.